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The ability to trade the financial markets historically relied on a hefty bank account or a job in a financial institution like an investment entity.
Nowadays, anyone can open a trade from their desktop, laptop or mobile device with little more than pocket change.
This is partly down to leverage.
It allows a trade to be opened using only a fraction of the notional amount, thanks to the ability to trade on margin (or margin trading) from your online brokerage. Rules surrounding leveraged trading differ depending on geographical jurisdiction and trading rules.
Depending on whether you’re trading physical shares—involves borrowing shares from your online share dealing broker when employing leverage—or trading derivatives products (involves trading contracts, and thus, no borrowing is undertaken when trading with leverage), leverage must be understood.
While leverage can be confusing for many, leverage is simply defined as the ability to control a larger position size in the Forex market than a trader or investor otherwise could without leverage (using no leverage would equate to a 1:1 leverage ratio). If you want to buy 10,000 euros in US dollars, for example, and the EUR/USD exchange rate was $1.2000, it would cost 12,000 USD without the use of leverage. Of course, this would be a costly endeavour for many traders, considering the minimal return potential. This is where margin and leverage step in.
Traders and investors employ margin to work with leverage in derivatives.
We know what leverage is, but what is margin?
Margin, or initial margin (or margin requirement), is a portion of your account held by your Forex broker to ensure you have the means to cover any potential losses. So, let’s say you’re trading the USD/CAD currency pair and your account is denominated in USD, with a leverage ratio of 1:100 on your trading account (this means that for every 1 USD in your account, you can control up to 100 USD). Suppose through your position size calculation (an important component of risk management) that you can open a standard lot size (the equivalent of 100,000 USD). In this example, you can find your margin percentage by dividing the leverage ratio (so, 1 / 100 = 0.01 or 1%). This is 1% of the notional position: $1,000 USD would be your required margin deposit to control a 100,000-unit position (this is the leverage). This is the nuts and bolts of how leverage is attained in the FX retail space.
The leverage level chosen only helps with the margin requirement. Higher leverage would mean less of a deposit (initial margin) to open a trade, and vice versa for lower leverage. So, what leverage ratio one decides on depends on the initial margin one is comfortable with.
Traders would be better focussed on understanding their risk tolerance and position sizing. This will ultimately determine the margin required and the leverage used. Technically, though, you can measure your effective leverage of a trade, found by dividing the notional value of your position by your account equity. If your position sizing calculation indicates you can take a 100,000-unit position and your account equity is 10,000 USD, then your effective leverage for this trade would be 10:1. If you added another 50,000 units to the same position and your account equity is 10,500 USD, then the effective leverage will have increased to approximately 14:1.
In conclusion, market participants need to understand that leverage acts like a double-edged sword. While it increases the chances of greater returns in the event of favourable market moves, it equally increases the chances of losses if an open position turns unfavourable. With effective risk management, a strong understanding of position sizing and a strong psychological awareness, leverage can be used in a productive manner, rather than cause account ruin.
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